Recent corporate governance reform trends in Japan

Practical Law UK Articles 8-522-5788 (Approx. 10 pages)

Recent corporate governance reform trends in Japan

by Atsutoshi Maeda and Yoshinori Aoyagi, Anderson Mori & Tomotsune

Amendments to the Companies Act

While the upcoming amendments to the Companies Act will cover various issues, the most widely discussed topic in the lead up to the amendments relate to outside directors (shagai-torishimariyaku). In particular, discussions regarding outside directors focused on the following:

Whether certain types of companies (including listed companies) should be required to appoint at least one outside director.
Amendments to the definition of "outside director".

Must companies have outside directors?

Currently, the Companies Act only requires those companies adopting the committee-type governance system (Committee Companies) to appoint outside directors. However, the committee type governance system has not been adopted by most Japanese listed companies. Traditionally, outside directors do not play central roles in corporate governance in Japan. The prevalent corporate governance system among Japanese listed companies involves a board of statutory auditors (kansayaku-kai) playing a central role (Companies with Statutory Auditors).

A board of statutory auditors must have at least three statutory auditors (kansayaku), the majority of which must be outside statutory auditors (shagai-kansayaku). The business operations of companies with a board of statutory auditors are handled by their representative director(s). The majority of directors (other than representative directors) of these companies are typically executive directors who are involved in the operation of the company based on delegations from the representative director(s). Statutory auditors audit the directors' business operations and the company's accounts. They also attend board meetings, although they do not have voting rights at these meetings. It has been argued that statutory auditors do not have enough power against directors and have no direct influence in a company's management due to their lack of voting rights at board meetings. Accordingly, proposals to introduce outside directors entitled to voting rights at board meetings would be a significant step forward from a corporate governance perspective.

It was debated during discussions on the upcoming amendments to the Companies Act whether the amendments should include a requirement for companies to appoint an outside director:

Some experts strongly supported the incorporation of such an obligation into the Companies Act in order to enhance corporate governance standards in Japan.
Others, citing reasons such as there being no evidence that appointments of outside directors would enhance corporate governance, were strongly opposed to the introduction of such an obligation.

Ultimately, the proposal for the mandatory appointment of outside directors was not included as part of the upcoming amendments to the Companies Act.

As an alternative to this requirement, however, a provision was included in the amendments, requiring companies without an outside director as of the end of the previous fiscal year to explain at an annual shareholders meeting the reasons why it considers the appointment of an outside director inappropriate. It has also been proposed that this requirement be applied to companies that are required to comply with the continuing disclosure rules under the Financial Instruments and Exchange Act of Japan (being typically listed companies). This is understood to be a form of the comply-or-explain approach, which has been employed in corporate governance in the UK and other European countries.

The Ordinance for Enforcement of the Companies Act (which is currently being drafted) is also expected to require such companies, if they do not have any outside directors, to set out the reasons why they consider the appointment of an outside director inappropriate in their annual business reports and proxy statements in respect of shareholders' meetings, if a proposal on the appointment of directors that is submitted to shareholders does not propose a candidate for an outside director. Any reason for the non-appointment of an outside director is also required to be based on the company's circumstances in light of the relevant financial year, and cannot be supported by such simple rationale as the company having already appointed outside statutory auditors.

In addition, it was also resolved at the Diet as a resolution accompanying the amendments to the Companies Act that the government will, two years after the coming into force of the upcoming amendments to the Companies Act, reconsider whether it is necessary to require companies to appoint outside directors or to make some other amendments, taking into account changes in socio-economic circumstances, including the prevalence of outside directors.

Who can be an outside director?

An outside director, as defined in the current Companies Act, is a director of a company who is not and has never been, among others, an executive director or an employee of the company or its subsidiaries, or a director of a parent company. Accordingly, the concept of an outside director under Japanese law is different from that of an independent director in most other jurisdictions, which generally do not include directors of a parent company.

The upcoming amendments to the Companies Act will, however, amend the definition of "outside director" to exclude the following categories of persons as well:

Current directors and employees of the relevant company's parent.
Current executive directors and employees of the relevant company's sister entities.
Relatives of current directors, officers and key employees of the relevant company.

Due to arguments that such narrowing of the definition of "outside director" will make it difficult for suitable outside director candidates to be found, the amended Companies Act will allow persons who had served as executive directors and employees of a company or its subsidiaries more than ten years in the past to become an outside director (such persons are currently not permitted to be outside directors). Similar amendments will also be made to the definition of "outside statutory auditor".

There are also other corporate governance-related amendments to the Companies Act in addition to those relating to outside directors, including the following:

The appointment of an accounting auditor by a board of statutory auditors.
The introduction of one-committee type companies.
The introduction of multiple derivative actions.

We briefly discuss each of these proposed amendments below.

Who can nominate an accounting auditor?

Under the current provisions of the Companies Act, a company's accounting auditor is elected at a shareholders' meeting. A company's board of directors has the power to propose to shareholders suitable candidates for the position of accounting auditors in most listed companies (that is, companies with a board of statutory auditors). In such companies, the board of statutory auditors has the power to consent or object to shareholders' election of accounting auditors. Accordingly, a board of directors has substantial discretion in determining the candidate for a company's accounting auditor and replacing an accounting auditor that does not serve the interests of the company.

The Companies Act will be amended to empower the board of statutory auditors to propose candidates for the position of accounting auditors (with the board having only the right to consent or object to such proposals). In view of the recent corporate scandals in Japan involving directors changing their accounting auditors for purposes of concealing fraudulent transactions, this amendment should increase the influence of accounting auditors and boards of statutory auditors, in addition to enhancing the independence of accounting auditors (and consequently, corporate governance standards in Japan).

Introduction of one-committee type companies

A Committee Company which adopts the existing committee-type governance system under the Companies Act of Japan is required to establish three committees, namely, the nomination committee, the remuneration committee and the audit committee. Most Japanese listed companies do not adopt this governance system because they are averse to the idea of establishing nomination and remuneration committees. Specifically, Japanese companies find it difficult to accept that candidates for a directorship and the remuneration of directors should be determined by committees where the majority members are outside directors.

The upcoming amendments to the Companies Act include the introduction of a new committee type governance system, under which a company is required to establish only an audit committee (which differs slightly from an audit committee under the above three-committee type system in terms of committee functions and certain other matters). The introduction of this new governance system will remove the requirement to establish three committees under the three-committee governance system. The new governance system will be introduced in order to induce Japanese companies to appoint outside directors. As with each committee under the three-committee governance system, the audit committee under this new governance system is also required to consist of at least three directors, at least two of which have to be outside directors.

Introduction of multiple derivative actions

Currently, the Companies Act permits a company shareholder to file a derivative action against the directors, statutory auditors and certain other personnel of a company. This ability to file a derivative action is based on the direct equity interests of the shareholder in the company. Accordingly, a shareholder is not permitted to bring a derivative action against, for example, a director of the relevant company’s subsidiary.

It was argued, in this regard, that the shareholders of a company should be able to bring derivative actions against the directors, statutory auditors and other personnel of the company's subsidiaries. This argument is based on the reasoning that subsidiaries led by a holding company (rather than the holding company itself) are typically the entities engaged in the businesses of the corporate group. In view of such an argument, the upcoming amendments to the Companies Act will introduce the concept of "multiple derivative actions", that enables a shareholder of an ultimate parent company to bring derivative actions against the directors, statutory auditors and some other personnel of the parent company's subsidiaries, in certain circumstances.

Circumstances under which such "multiple derivative actions" may be brought are as follows:

The relevant subsidiary must be directly or indirectly wholly-owned by the ultimate parent company.
The relevant shareholder(s) must have been holding at least 1% of the voting rights in the ultimate parent company for at least six months. On the other hand, a shareholder of a company is only required under the Companies Act to have one share (which must also have been held for at least six months) in order to have the right to bring (non-multiple) derivative actions against the directors, statutory auditors and other personnel of the company.
The book value of the shares of the relevant subsidiary must be at least one fifth of the value of the total assets of the ultimate parent company, as of the date on which the relevant fact forming the basis of the multiple derivative action occurred.

Independent officers under the Listing Rules

Japanese stock exchanges have required listed companies to appoint "independent officers" since 2009. An independent officer must be appointed by each listed company from among outside directors or outside statutory auditors whose interest does not conflict with that of the company. The relevant stock exchange must also be notified of the appointment. Under this requirement, the following persons would, in principle, be ineligible for the position of independent officer:

Executives or employees of parent companies and sister companies.
Key business partners (such as suppliers, clients and the like) and their executives or employees.
Consultants and accounting and legal experts who receive substantial compensation from the relevant listed companies.
Persons who have recently been any of the above.

This concept of independence is similar to that of "independent directors" in other jurisdictions, although an "independent officer" under the Listing Rules includes a statutory auditor.

Amendments to the Listing Rules, which were discussed in parallel with the upcoming amendments to the Companies Act, were implemented ahead of the coming into force of the amendments to the Companies Act. Although the upcoming amendments to the Companies Act will not require companies to appoint an outside director, the amended Listing Rules were amended to require listed companies to "endeavour" to elect at least one independent director.

Just as the upcoming amendments to the Companies Act will require Japanese listed companies that have not appointed an outside director to explain why such an appointment is inappropriate at shareholders’ meetings and in their annual business reports and proxy statements for shareholders’ meetings (see above, Must companies have outside directors?), listed companies will also have to endeavour to appoint independent directors (excluding directors transferred from its key business partners). Together with the upcoming amendments to the Companies Act, these amendments to the Listing Rules have seemingly resulted in an increase in the number of outside directors appointed this year. In this regard, the upcoming amendments to the Companies Act will require companies to appoint outside directors by the end of the fiscal year that ends before April or May 2015 in order to avoid having to explain why they have omitted to appoint any outside directors. Based on the latest corporate governance reports issued by Japanese listed companies, 64.4% of the companies listed on the Tokyo Stock Exchange have outside directors as of 14 July 2014, compared to only 54.2% as of the end of August 2013.

Other trends in relation to corporate governance in Japan

There have also been several other important developments in the area of corporate governance in Japan in addition to the amended Listing Rules and upcoming amendments to the Companies Act. These developments are discussed below.

Drafting of Corporate Governance Code

It was stated in the revised "Japan Revitalization Strategy" resolved by the Cabinet as of 24 June 2014 (the Strategy) that the Tokyo Stock Exchange will draft the Corporate Governance Code. Public listed companies will have to comply with the Corporate Governance Code once it becomes effective, or otherwise explain why they have not complied with it. It was also stated in the Strategy that the Corporate Governance Code will specify the principles of corporate governance to be applied by listed companies, and will incorporate, among others, the Tokyo Stock Exchange's existing rules and guidelines regarding corporate governance, and the OECD Principles of Corporate Governance.

A council of experts, with the Tokyo Stock Exchange and the Financial Services Agency of Japan jointly acting as secretariat, will aim to prepare the key elements of the Corporate Governance Code by around the end of autumn of 2014, to enable the Tokyo Stock Exchange to draft the Corporate Governance Code anew in time for general shareholders' meetings in 2015 (such meetings typically taking place in June).

The Corporate Governance Code will be based on the "comply or explain" approach, which is similar to that of the UK Corporate Governance Code and similar codes of other countries.

Promotion of board diversity

Policymakers are also aiming at increasing diversity, including female representation in the boards of Japanese listed companies. It is stated in the Strategy that the government of Japan will require:

Companies that are subject to the disclosure requirements of the Financial Instruments and Exchange Act (being mostly listed companies) to specify the proportion of women in executive posts in its Annual Securities Report issued under the Financial Instruments and Exchange Act.
Japanese stock exchanges to direct listed companies to include, in their Corporate Governance Reports, information regarding their appointment of women to executive and managerial positions, and initiatives being taken to promote such appointments.

The Ministry of Economy, Trade and Industry and the Tokyo Stock Exchange had already begun in 2012 to compile a list of listed companies which are promoting the appointment of women to executive and managerial positions, and has categorised such companies under the "Nadeshiko Brand" (Nadeshiko, which is the Japanese name of a flower, is also used to refer to Japanese women).

Influence of the Japanese Stewardship Code

The Japanese Stewardship Code was published on 26 February 2014 by a council of experts established by the Financial Services Agency of Japan. It stipulates the code of conduct for institutional investors investing in Japanese listed companies, and was modelled after the Stewardship Code of the UK. While institutional investors are not required to comply with the Stewardship Code, they can voluntarily express their intention to be in compliance with this Code (such expression of intention being required to be notified to the Financial Services Agency of Japan). Institutional investors that have expressed such an intention will be required to explain any failure to comply with the Stewardship Code.

As of 10 June 2014, 127 investors have expressed their intention to comply with the Stewardship Code. Among other principles, the Stewardship Code stipulates that institutional investors should seek to arrive at a common understanding with their investee companies and to resolve problems through "constructive engagement" with investee companies. The Stewardship Code also stipulates that institutional investors should formulate clear policies on voting and disclosure of voting activities in respect of their investee companies.

Institutional investors have become more influential in Japanese listed companies in recent years even though they have operated without the Stewardship Code, which was only recently published. With the publication of the Stewardship Code, the influence of such institutional investors in Japanese listed companies is expected to further increase through their constructive engagement and disclosure of voting activity in respect of their investee companies. This development, together with the anticipated increase in the appointments of outside directors pursuant to the upcoming amendments to the Companies Act, the newly stipulated Corporate Governance Code, and the recent changes to the Listing Rules, is expected to enhance the corporate governance standards of Japanese listed companies.

Contributor profiles

Atsutoshi Maeda

Anderson Mori & Tomotsune

Image 1 within Recent corporate governance reform trends in Japan

T +81 3 6888 1083
F +81 3 6888 3083
E [email protected]
W www.amt-law.com

Professional qualifications. Japan, 2000

Areas of practice. Corporate and M&A; financial regulation; structured finance; real estate transactions.

Recent transactions

Advising an automotive parts manufacturer on its acquisition from a test and measurement products manufacturing company of its automotive diagnostic equipment business.
Advising a US private equity firm on its acquisition of shares in a wireless electrical communication software company.
Advising a US private equity firm on its acquisition of shares in a communication devices and network management software company.

Yoshinori Aoyagi

Anderson Mori & Tomotsune

Image 2 within Recent corporate governance reform trends in Japan

T +81 3 6888 1109
F +81 3 6888 3109
E [email protected]
W www.amt-law.com

Qualified. Japan, 2001; New York, 2009

Areas of practice. Corporate and M&A; capital markets; competition.

Recent transactions

Advising a Japan-listed Cayman company on an MBO transaction.
Advising a Japan-listed US company on a third party allotment.
Advising a Japan-listed automotive parts company on its acquisition from another Japan-listed company of its automotive parts-related business.

Recent corporate governance reform trends in Japan | Practical Law